Sustainable plans and debt

This paper presents a simple general equilibrium model of optimal fiscal policy similar to that of Lucas and Stokey (J. Monet. Econ.12 (1983), 55-93), except that we let the government default on its debt. We consider sustainable equilibria in which both government and private agent decision rules are required to be sequentially rational. We concentrate on trigger mechanisms which specify reversion to the Markov equilibrium after deviations by the government and show that such mechanisms cannot support equilibria with positive debt. We go on to show by way of examples that there can be more complicated trigger mechanisms which support positive debt. Journal of Economic Literature Classification Numbers: E61, E62.